Economic Survey calculates black money by actually measuring how dirty notes were

The Economic Survey, tabled in Parliament on Tuesday, devotes an entire chapter to demonetisation. The document, an annual report on the state of the Indian economy, offers the most comprehensive examination of Prime Minister Narendra Modi’s currency exchange effort yet, although it concludes by saying that there isn’t enough data to estimate its full impact so far. While figuring out how to understand the effect of demonetisation, the Survey attempts to measure how much cash was being used as black money through an unusual metric: How dirty the notes were.

The survey points out that India has a high amount of cash relative to its Gross Domestic Product. And Reserve Bank of India data suggests that much of this cash was in high-value notes, amounting to something like 86% of all currency in circulation.

To put this into context, the Survey compared cash-to-GDP ratio of various countries against their per capita income, finding that India has a high amount of cash in its economy when compared to most other countries in the same income bracket.

“This might seem to suggest that some of the cash holdings were not being used for legitimate transactions, but perhaps for other activities such as corruption,” the Survey says. “This presumption is especially strong because across the globe there is a link between cash and nefarious activities: the higher the amount of cash in circulation, the greater the amount of corruption, as measured by Transparency International.”

Even then the data seems somewhat anomalous, the Survey says, since India still has a relatively high amount of cash even for the estimated amount of corruption in the system. That brings up two possibilities: Either India is much more corrupt than the estimate, or cash is being used for legitimate purposes.

Allowing for the fact that cash may be necessary in India, the Survey goes on to ask the question of whether high-value notes are required. Some of the data here suggests that they are useful, since incomes have gone up and the Rs 1,000 note wasn’t particularly high denomination compared to many other countries.

But the Survey goes further in trying to figure out how many of these notes were actually being used for transactions, instead of just being stored – presumably as black money.

“Perhaps the most conclusive evidence on the extent to which Rs 500 and Rs 1,000 notes are used for transactions comes from data on “soil rates,” that is the rate at which notes are considered to be too damaged to use and have been returned to the central bank.”

In other words, if the notes were actually being used for transactions, they would probably be getting dirty or damaged quicker. If they were being used to store black money, they would take longer to get soiled.

The Survey doesn’t presume all these notes should be soiled at the same rate, since naturally there would be many more transactions of lower-value notes than the high-value ones. To estimate how many high-value notes are actually used in transactions, however, it compares the rate to comparable American dollar notes and concludes that a large amount of Indian rupees – Rs 3 lakh crore – is just being stored, not transacted with, and so “potentially black.”

“Using relative soil rates for the US $50 and $20 notes and applying them to comparable Indian high denomination notes, yields an estimate of the amount not used for transactions, and hence potentially black, of about Rs 3 lakh crore. This is substantial, as it represents about 2 percent of GDP.”  

Until this conclusion, which the Survey admits is imperfect, there had been no official estimation of how much black money was being held in the country, let alone how much of it was held in cash. This doesn’t count as an official estimate either – the government isn’t making any calculations on the basis of this – but it might be a useful marker for how to measure “potential” black money in the future.

Will the new Rs 500 and Rs 2,000 notes get soiled faster?